Mutual Funds

We often get queries from investors, enquiring about best debt mutual funds. Some investors want stable income and low volatility in a rising interest rate scenario; accrual based short duration debt funds are suited for such investors. Some investors, on the other hand, want high returns in favorable interest rate scenario; long duration funds are best suited in such an environment. Long duration funds tend to underperform in a rising interest rate environment, while short duration funds will not be able to match returns of long duration funds in a falling interest rate environment.

Different duration strategies work in different interest rate scenarios. If investors want to maximize returns over a sufficiently long investment horizon, irrespective of changing interest rate scenarios, then they have to switch between long duration and short duration debt mutual funds depending on interest rate outlook. However, taking interest rate calls require expertise, which are often beyond the capabilities of the average retail investor. Yields can reach inflection points much before the average investor can anticipate. It is also difficult for average retail investors to understand which maturity profiles they should invest based on changing yield curve shapes. Further, switching between debt mutual funds has capital gains tax implications; if you switch between debt mutual funds before 3 years from investment date, then your capital gains will be added to your income and taxed as per you income tax rate.

Dynamic bond funds are ideal investment options for investors with sufficiently long investment tenors, who want to get good returns irrespective of interest rate situations prevailing in the interim. These funds have a flexible duration strategy and invest across durations; when yields bottom out, these funds switch to a long duration strategy and when yields are high, they switch from a long duration to a short duration strategy – hence the name dynamic bond fund.

Consistent Performance of ICICI Prudential All Season Bond Fund

The true performance test of a top performing dynamic bond fund is not whether the fund has given the highest returns in the last one or two years; a dynamic bond fund can outperform others in a particular period by adopting a conservative or aggressive duration strategy relative to interest rate scenario prevailing in the particular period. The true test of a dynamic bond fund’s performance is consistency of performance in all interest rate scenarios.

You can see that ICICI Prudential All Season Bond Fund was in the top quartiles in the 4 out the last 5 years. ICICI Prudential All Season Bond Fund outperformed the dynamic bond fund category in terms of trailing returns across all time-scales (see the chart below).

Duration Strategy

ICICI Prudential All Seasons Bond Fund modified duration is maintained in a range of 1-10 years based on an in-house model. The scheme takes duration calls based on an in-house Current Account (CA) Model and absolute G-Sec yield levels. The Current Account Model is based on three parameters:-

Current Account Deficit

Fiscal Deficit

Credit Growth

Whenever the Current Account index level moves higher, the scheme increases duration and when the CA index is negative, the scheme decreases duration. The Current Account Model parameters are now prompting reduction in duration because of the following factors:-

Current Account Deficit:

Crude oil prices are increasing. Exports are continuing to lag

Fiscal Deficit:

Higher possibility of fiscal slippage due to Government spending. The April to August 2018 fiscal deficit is already nearly 95% of the full year (FY 19) target. GST collection needs to be monitored. Though GST collection is ramping up, it is still short of the Rs 1 Trillion monthly target.

Credit Growth:

Credit Growth has risen to 12.9% Year-on-Year as of August 2018.

These indicators have prompted a lowering of portfolio modified duration to 1.22 years.

ICICI Prudential All Seasons Bond Fund managed the maturity profile of its portfolio based on the yield curve shape in different interest rate scenarios. The positioning of portfolio maturity profile of the scheme in 2015, when yields were expected to decline, was towards the long end of the curve – 20 years maturity. The positioning of portfolio maturity profile of the scheme in 2018, when yields are expected to rise further for reasons explained above (based on the CA model), is towards the shorter end of the curve – 1.7 years maturity.

Source: ICICI Prudential

ICICI Prudential All Seasons Bond Fund has actively managed duration in various interest rate scenarios. The chart below shows the duration profile of the portfolio versus different 10 year Government Bond yield scenarios over the last 5 years or so.

How ICICI Prudential All Seasons Bond Fund managed volatility in the last 12 months or so

Source: ICICI Prudential

Theoretical Basis of how dynamic bond funds give good returns in different interest rate scenarios

We have seen thus far how ICICI Prudential All Seasons Bond Fund managed its portfolio duration in different interest rate scenarios. We will now see how investors benefit from dynamic duration management based on interest rate outlook. Let us assume yields (interest rates) fall by 50 bps over the next three years.

Source: ICICI Prudential

You can see that based on the duration and YTM assumptions, the scheme will give excellent returns in a falling interest rate scenario. For the experienced investors among our readers this may be a no brainer, but let us see how the scheme will perform when interest rates are rising; YTM starting assumption remains the same, but the portfolio duration will be reduced in such an environment, based on ICICI Prudential’s in-house Current Account Model. Let us assume duration is 1 year in a rising interest rate scenario.

Source: ICICI Prudential

You can see that the scheme gives good returns (higher than risk free rate), even in a rising interest rate scenario. Obviously, these are theoretical scenarios and there will be transition period between the two duration strategies, where returns will be low due to price depreciation on account of interest rate changes. Therefore, investors should have a sufficiently long investment horizon, typically 3 years or more (ideally), to get the best returns from a dynamic bond fund.

Over a 3 years plus investment tenor, debt mutual fund investors can also get substantial tax advantage on their returns. Long term capital gains tax (investments held for 3 years or more) are taxed at 20%, after allowing for indexation benefits. Indexation benefits reduce the effective tax rate to much below 20%. Therefore, debt mutual funds have a huge tax advantage over traditional fixed income products like bank fixed deposits and Government Small Savings Schemes, where the interest is usually taxed as per the income tax rate of the investor.

Why ICICI Prudential All Seasons Bond Fund for medium to long term debt investments?

The scheme has the ability to generate reasonable returns in all kinds of market scenarios. As yields are expected to trend lower in the future, the scheme can flexibly increase duration and when yields bottom out, the scheme will start playing accrual strategy.

Suitable for Current Market Conditions (Why now):

Currently the scheme is well-positioned to benefit from any volatility in yields due to volatile oil prices, rising US treasury yields, depreciating INR. The scheme has a low modified duration of 1.22 years (as on August 31, 2018) to reduce the effect of market volatility

Tactical Calls between G-Sec & Corporate Bonds (maximizing yields):

The scheme will take tactical calls whether to invest in G-Sec or Corporate Bonds (non-convertible debentures) based on interest rate situation. If yields are high and expected to fall, then scheme is likely to invest in long dated Government Bonds (G-Secs). When yields are high and rising, the scheme will try to capture higher yields by investing in corporate bonds. The spread between G-Sec and highest rated (AAA) corporate bonds is currently around 50 bps. Since yields are high, the scheme intends to invest in higher yielding credit papers.

In this blog post, we discussed how dynamic bond funds are ideally suited for investors who want to get good returns over a sufficiently long investment horizon (3 years or more), irrespective of prevailing interest rate situations in the interim. ICICI Prudential All Seasons Bond Fund is one of the best dynamic bond funds, based on its consistent performance in the last 5 years. It has given the highest return in its category over the last 3 to 5 years. Investors with moderate risk profiles should consult with their financial advisors if ICICI Prudential All Seasons Bond Fund is suitable for their investment needs.

Advisorkhoj Research Team

Our research team has a combined experience of nearly 40 years in the
financial services management and distribution, across the entire
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